Subprime policy recommendations

Congress should simply outlaw adjustable-rate mortgages, which
basically ask borrowers to treat their home mortgages like stocks…Congress should also ban private lenders and brokers from issuing
sub-prime loans of any kind.

I am curious as to whether subprime marriages should be outlawed as well. Starting a small business? How about having a kid? Of course we shouldn’t give them credit cards. Outlawing loan sharks will be easy too.

The weakness of these policy recommendations is a sign of how lost our current understanding is. In most policy areas, the left has a better idea than simply shutting down the market. The reality is that we don’t know how to legislate against bubbles. Nor is it mentioned that there’s not a clear definition of what a subprime loan is or how such a ban would be enforced in practice. Remember the good ol’ days when Joseph Stiglitz argued that credit rationing meant that banks made too few loans to high-risk borrowers?

Here is the much longer piece, which has a good deal of content. The economic history in the linked article is very, very wrong, no matter what your political point of view. Imagine discussing the S&L crisis of the early 1980s without even mentioning the high inflation of the late 1970s or the resulting low levels of bank capitalization. It’s fair enough to blame the right for relative silence on the real estate bubble — a clear case of market failure — but this article has to go in the Hall of Shame.

You will get no argument from me about the over-simplicity of these recommendations, but I don’t think it’s worthy of the Hall of Shame. Perhaps if these are acted upon, but currently these suggestions are just whistling in the dark. HoS caliber policy recommendations are things like “Tax cuts increase revenue.” or “Deficits don’t matter.”

I thought that a (the?) real cause of this event was that loans were not being serviced by loan consolidators and it is difficult for borrowers and loan owners to renegotiate terms of a loan to their mutual benefit. Allowing some mechanism of mutually beneficial renegotiation sounds like it couldn’t be a bad thing.

The pendulum swings. That snippet is pretty silly, but we are still coming from decades of indecent debt-love. We still stack kids today with college loans bigger than my first mortgage … and my first mortgage wasn’t that long ago.

meterDecember 21, 2007 at 9:24 am

Duh. Government WAS out of it. Look what happened.

jpDecember 21, 2007 at 9:46 am

The reality is that we don’t know how to legislate against bubbles.

. . . the real estate bubble — a clear case of market failure . . . .

Serious questions: If by “market failure” we mean something bad that warrants government interference, are bubbles really market failures? Are boom-and-bust cycles market failures? Would it not be better to accept them as normal variations?

FWIW, subprime-mortgage pain seems to me like a once-burned type of thing, comparable to the off-balance-sheet liabilities of Enron. Clever people came up with a product or framework that most observers were unfamiliar with and didn’t completely understand, and we/they then learned the hard way. We now “know” about those risks (the same way we “know” about the risks of what our great-grandparents called watered stock and the risks of lending to undercapitalized entities), and we can and will deal with them through voluntary arrangements going forward.

jorodDecember 21, 2007 at 9:52 am

Aristotle observed that one of the causes of the failure of democracies is the rise of the demagogues. We are seeing an ample supply of demagogues arising from the Democrat party. Hilary, Obama, Edwards, Dean, Biden, Rangel, etc. No brains, all talk.

Who is this “we” loading college students up on debt (and engaging in “indecent debt-love”)?

Whose choice is it for a student to go to a more or less expensive school, to work or not work summers or work or not work during school, to attend part-time rather than full-time, to attend a less expensive community college for the first two years, to explore other means of paying for college like ROTC, or working and saving for a few years then going to school? “We”? Oh, the inhumanity of it all!

btw – what does “decent debt-love” look like?

KenDecember 21, 2007 at 10:09 am

I see the start of a new meme. Wall Street wasn’t driven to subprime by the crazy money that could be made. They were just trying to appease the libruls crying out for broader home-ownership.

Blame Joseph Stiglitz!

jrDecember 21, 2007 at 10:26 am

I think people go a bit crazy here in the US, but it’s not like those albania ponzi schemes that you read about. There will always be a percentage of the population gamble in any market.

jpDecember 21, 2007 at 10:45 am

The feedback loop between easier loans and higher tuition should be obvious to any observer.

Homeownership in the US went from 64 to 69% from 1994 to 2005, after holding steady for decades. In particular, many of the new homeowners were low-income and minority. Almost by definition, more people with bad credit will default than people with good credit. After the “crisis” is over, we’ll still have a market where many more people owned homes than any time in American history.

As an economist, I just don’t see foreclosures as a major problem. Investors who funded mortgage brokers and bought securities made a bad bet about the risk of house price declines, but that’s the nature of investing. The vast majority who “lose their house” haven’t even made 2 years of payments yet, and many of the foreclosures are investment properties and multifamily homes. On the other side of the ledger, the 80% of subprimes who are paying their bills surely can’t be too upset that they no longer have a landlord.

ZachDecember 21, 2007 at 11:03 am

“Working through the summer” to reduce student debt is a relic of an older pricing model. The model now is

1) College sets ridiculously high tuition — well above $30,000 / year
2) Nobody can pay ridiculously high tuition.
3) Everybody submits full financial information that reveals exactly how much they can afford to pay, including taking on debt.
4) A miracle occurs! The college gives “financial aid” to lower the price to the level settled upon in step 3.

It’s a purely discriminatory price model. Bargains may exist from state colleges or jucos, but if you go to a private school, you will take on debt, even with a student job. The college doesn’t leave any money on the table, even money that you have to borrow to put on the table.

meterDecember 21, 2007 at 11:15 am

The problem is that this is not a case where only two parties (mortgager/mortgagee) are affected. With the tranching, leveraging, and all the other financial shenanigans encouraged by “the market”, this has affected such innocent parties as:

– retirees (see: State of Florida)
– people with honest home purchases who are now sitting in ghost-town-like neighborhoods (see: Arizona)
– those invested in certain funds (see: Bear Sterns)
– insurers (see: MBIA)

M. Hodak, I’m curious how this outcome could have been WORSE had there been governmental regulation of mortgage terms. Please paint us a picture.

A significant factor in this meltdown was fraud; we have agencies and laws to investigate and prosecute fraud in other realms (see: SEC), but I suppose you’re in favor of the invisible hand of the market weeding out those dumb enough to get sucked into this mess (see: list above which is not remotely a full list of those affected.)

DKDecember 21, 2007 at 11:32 am

Why are ARM’s such a target? I still don’t see ANY reason why ARM’s are a bad idea for creditworthy people. I would be tens-of-thousands better off today if I had bought my house 4 years ago with an ARM and refinanced it to a fixed mortgage this year instead of choosing fixed from the beginning. Yes, option ARM’s and negative-AM ARM’s and subprime ARM’s are terrible, but I know many people who gained from their prime hybrid ARM’s.

And most corporate lending is on ARM terms, or is fixed rate debt swapped so the coroporation pays a floating rate. Do we believe they are behaving irrationally?

p.s. My best sentence of the day goes to Odograph’s “This was broadly a cultural error, not strictly market, and not strictly governmental.” Well put, and true for most of the left/right arguments here.

jorodDecember 21, 2007 at 12:38 pm

The subprime mess is just a variation of the HUD scam of the 60s and 70s. Only this time the suckers are the investors instead of the taxpayers.

ChrisDecember 21, 2007 at 1:44 pm

A ban on ARMs is an idiotic idea. For many people, they make perfect sense. Example: You know you’re going to move before the ARM adjusts upward. I had a 3.875 percent five-year ARM that cut my monthly payment and let me reduce the principle I owed more quickly. Three years later I moved to a bigger house. I made out like a bandit.

So long as there is a substantial gap between the 5- and 7-year ARMs and the 30-year fixed (there isn’t always), they are an obvious choice for someone who expects to move or move up.

JPCDecember 21, 2007 at 1:54 pm

The bigger picture here is this:

1. Pension funds are looking for yield enhanced investments to reduce their funding costs. These pension funds are not typically run by the savviest of investors.

2. Wall St provides yield-enhanced investments in the form of CDOs and the like. Wall St understands these investments better than the purchasers. Still, Wall St must agree to make markets in these investments, and hold a considerable inventory of unsold or repurchased product.

3. The ratings agencies are operated by individuals with skill sets intermediary between Wall St. and the pension fund community. They are paid by Wall St. to credit rate these products, which are coming out in ever increasing number and complexity. The pension community trusts the ratings agencies to scrub down these products, but since they are paid by Wall St the independence value of the ratings is suspect.

4. The ratings are based on certain assumptions about loan performance, considered to be reasonable by historical standards, and don’t fully incorporate obvious market conditions like the housing price bubble. The ratings turn out to seriously underestimate the risk of these loans – mostly with regard to the minimal equity involved. As housing prices drop, the equity becomes negative.

5. Since these subprime and ARM loans can be packaged and sold with rating agency approval, and since the pension fund community will therefore buy them, the loans get made.

6. It’s hard to argue that people who should not have gotten loans are “victims” – especially in non-recourse states [ie lenders can’t go after borrowers for negative equity situations, the house is only collateral on loan]. If they lose their homes they are back to renting, probably not much worse off than before. A good reform might be to make all states non-recourse states. That would discipline a lot of the leverage of the lending. The bells and whistles on the interest payments on the loans are not the real problem – the negative equity is.

7. The pensioners are losers here. The real problem for them was trusting the ratings agencies who are proven here to be incompetent/not fully independent. However, given the big losses on Wall St, it’s hard to argue that the pain hasn’t been somewhat shared. It might be a good idea for the pension funds to start their own independent ratings agencies. The existing agencies have had a long monopoly and like any business, serve those who pay them. This is a lot like the accounting independence issues circa Enron.

JP CDecember 21, 2007 at 2:29 pm

1. The real concern here seems to be the possibility of financial crisis caused by losses in a handful of banks who held big inventories of these loans/securities. I don’t think we have quite seen how big that crisis is yet, but it seems to be working itself out.

2. The “losses” in the housing market are still small compared to the gains over the past 10 yrs, but those who bought at the peak have lost money. That is not a new type of market phenomenon, and the magnitude is still much less than the stock market correction of 7 yrs ago. The similarities are obvious: a long advertised, much discussed bubble, new players and technology for accessing the market with more leverage, bad incentives for the institutions responsible for analyzing market risks to the average investor.

3. Pension funds and insurance companies are the largest and best sources of capital to take these risks and absorb these losses. They need to get smarter, and get better independent advice.

SJEDecember 21, 2007 at 7:06 pm

While I feel sorry for those who will loose a lot of money, at the macro level, I see far more benefits.
1. The articles notes that as many as 2 million of the 7 million subprime borrowers would default. This means that new credit instruments such as ARMs allowed 5 million people to become homeowners, definitely a net benefit.

2. The oft-repeated cry about people losing their homes: how true is that? I would be willing to bet that the vast majority of those who defaulted were in early stages of an ARM mortgage or an interest only mortgage, and therefore had almost no equity. Granted, they lose the emotionally significant “home,” but do they really lose so much money? Does anyone have any figures on how much personal liability these people will bear.

3. A real scandal that seems to be lost in all of this is the large transaction fees charged by real-estate agents, loan originators, and State and local transfer taxes, such that the buyer has a lot of sunk costs. They also make it difficult for those who are finding themselves unable to afford their loan to sell, thereby forcing them to default. Of course, a lot of those charges could be fixed by governments reducing their transfer taxes, finding ways to weaken the monopolies held by those who are involved in the sale etc, deregulating generally etc. The fact that real estate agents were earning 5% commission in a booming market (i.e. for little work), suggest that the market was not working. This argues for more market-based approaches, not less.

“The articles notes that as many as 2 million of the 7 million subprime borrowers would default. This means that new credit instruments such as ARMs allowed 5 million people to become homeowners, definitely a net benefit.”

If I were going to be a curmudgeon I’d ask how many of those, and really the highly leveraged buyers across the income spectrum, will truly become owners. The old joke for a new buyer is that “the bank owns the house, and I get to live in it.” That’s the first step in home ownership but to complete it you’ve got to pay it down.

I get the feeling that people around me were trading up and expanding debt at the same time.

Given the declining US savings rate, and the declining home equity ratio, that had to be happening on a national basis.

Is this really an expansion in “ownership?”

meterDecember 22, 2007 at 4:46 pm

The more I read comments here, the more I become convinced that the free-marketeers are harkening back to the times of the Greek agora, or calling for some kind of modern-day global souk in which transactions are simple (between only two parties) and without nefarious intention. There is almost a willful dismissal of 21st century reality.

No proof exists that a free and open market without government intervention will eliminate the fraud, imbalances, and all concomitant perils faced in the present day. The spin is that these perils are a feature, not a bug in free-market-speak whereas they’re denigrated in a government-regulated environment.

I especially love this: the current housing situation isn’t a bubble (because it had nothing to do with the government), but rather a natural market fluctuation. The toilet-bowling of the US dollar is contrarily denigrated as the fault of the government (Fed) – it couldn’t possibly be due to market-oriented forces. E.g. the fact that our spending is out of control, that we’re untrustworthy and wholly irresponsible as a nation, etc.

Don’t like the government? Neither do I. Get a better one. Elimination of transactional regulation and consumer protection is folly to the nth degree.

meter, what if consumer protection was, in the main, harmful? Would you then be in favor of abolishing ALL of it? Obviously your answer will be “well, we should fix the parts that don’t work” — to which I ask “why haven’t we already done that?” If it were possible, we would have done it already. My conclusion is that consumer protection is not fixable and should be abolished.

AnonymousDecember 23, 2007 at 3:22 pm

@meter,

The more I read comments here, the more I become convinced that the free-marketeers are harkening back to the times of the Greek agora, or calling for some kind of modern-day global souk in which transactions are simple (between only two parties) and without nefarious intention. There is almost a willful dismissal of 21st century reality.

No proof exists that a free and open market without government intervention will eliminate the fraud, imbalances, and all concomitant perils faced in the present day.

Eliminate? No, of course not. It will reduce fraud, imbalances, and all sorts of perils to a level that people demand, and no less. While there is no “proof” of this (there have never been perfectly free markets any more than there have ever been perfect command economies), a very good example of the market working well is the Internet. It has no regulation whatsoever. Yes, there is fraud (much of it is aimed at an older generation not able to cope with new technology), but there has never been an “Internet business cycle” that caused any sort of harm. I’ve never heard of a “bubble” in blogs, for instance.

As for your question “if it were better with no government why haven’t we done that?”, thats a bit easier said than done. Governments exist because people would rather pay taxes than be subject to the penalties of not paying taxes. Regardless of whether they are beneficial or not, they don’t simply go away or change if people want them to.